The Financial Post takes a weekly look at tools that will help you make your investment decisions. This week: the gap between the average dividend yield on a market benchmark and the yield on long-term government debt can offer a signal on when to buy stocks.

Current bond yields can tell equity investors a lot about the value of their investments, particularly when compared to the yields being generated by their holdings.

But the rise and fall of bond yields over time can be just as important in figuring out what direction stocks may be heading.

There are several methods to assess the value of stocks using bond yields including the yield gap, a popular tool that can often indicate whether equity markets are overvalued or undervalued compared to government bonds.

The gap is calculated by taking the difference between the average dividend yield on a market benchmark and the yield on long-term government debt.

For example, the yield gap in Canada is currently a positive 122 basis points based on the 2.99% dividend yield of the S&P/TSX composite index and 10-year government bond yield of 1.77%.

South of the border, the gap between the S&P 500 dividend yield and 10-year treasuries is less significant, but still positive at 27 basis points.

In theory, the more positive the gap, the greater the opportunity there is to buy into equity markets, particularly during inflationary times.

But when consumer prices are relatively stable, as they are today, positive gaps are far less indicative because investors tend to accept lower yields from bonds when the threat of inflation is low.

Another measurement that is frequently used by investors is the bond equity earnings yield ratio (BEER), which is calculated by dividing the bond yield, usually of a five- or 10-year government bond, by the current earnings yield — an inverted price-to-earnings ratio — of a stock benchmark in the same market.

Generally a BEER value greater than one indicates stock markets are overvalued, while a reading less than one suggests the opposite.

At the moment, the BEER on both sides of the border is well below one suggesting, just as the yield gap does, that stocks are cheap in comparison to bonds. Put together, they make a strong case in favour of equities, one that has handsomely paid off in recent months.

But the eventual rise in bond yields from today’s historically low levels has many stock investors worried.

“Many expect bond yields to finally begin rising again in the next few years which may suggest the need for increased caution in the stock market,” said Jim Paulsen, chief investment strategist at U.S.-based Wells Capital Management.

Mr. Paulsen thinks this eventuality may prove far less challenging than most anticipate, because rising bond yields aren’t always been bad for stocks, although that is a commonly-held belief.

Since 1950 there have been two distinct relationships between bond yields and price-to-earnings multiples on the U.S. stock market.

When yields are above 6%, the stock market’s P/E multiple falls approximately 1.5 points for every 1% rise in the 10-year bond yield.

However, when the yield has been below 6%, as it is now, the P/E multiple rises by about 3.25 points for every 1% increase in the bond yield.

“Indeed, PE multiples tend to rise with bond yields when yields are below 6% and even bond yields as high as 6 to 8% have been compatible with fairly strong PE multiples (about 17.3 times on average),” Mr. Paulsen said.

He isn’t sure why this is the case, but said bond yields below 6% may suggest subpar economic growth requiring an above-average “recession risk assessment” in stock valuations.

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